Monday, August 26, 2013

I continue to believe that the market is dominated by pessimism rather than optimism. Or, if you will, that there is a shortage of optimism.

What follows are some 20 or so charts, in random order, which highlight optimistic developments in the economy and financial markets which I believe are underappreciated. They paint a picture of an economy that is stronger and more durable than the skeptics seem to believe. There's still plenty of room for improvement, to be sure, but there are few if any signs of deterioration.

Banks have increased their lending to small and medium-sized businesses by almost $400 billion in less than 3 years. This reflects increasing optimism on the part of banks (who are more willing to lend) and on the part of businesses (who are more willing to borrow). There are undoubtedly many businesses that have been unable to obtain loans for worthwhile projects, but their number is definitely declining on the margin. One of the key factors holding the economy back in recent years is a lack of confidence; banks have been reluctant to lend, and businesses have been reluctant to borrow. This is all symptomatic of the deleveraging that has been the national pastime for most of the current recovery but which is slowly fading away.

Consumers have also been working to deleverage, and it shows in the three charts above. Delinquency rates on credit cards and consumer loans in general have fallen to the lowest level in recent history, while credit card loan chargeoff rates have plunged to levels rarely seen in the past. Households' financial burdens (monthly payments as a % of disposable income) have fallen to their lowest level in many decades. Consumers on average are in much better financial health these days than they have been for a long time.

Credit spreads are excellent indicators of the health of corporate balance sheets and cash flow. Spreads today are very near their post-recession lows, which marks significant progress from the terrifying heights of the past recession. But spreads are still substantially higher than they have been at their previous lows. We've made great progress, but there is still room for improvement. It's worth noting that even with the current scare over the approaching "tapering" of QE, credit markets reflect absolutely no increase in systemic risk. Investors and analysts may be spooked by tapering, but the bond market is behaving as though it is going to be a non-event.

The number of people receiving unemployment insurance has been declining steadily and significantly for over four years. There are 1.15 million fewer people "on the dole" today than there were a year ago, and that's a sizable reduction of over 20%. This is creating healthier incentives in the workforce, since it means many of the unemployed have a stronger incentive today to find and accept a job.

Mortgage rates are up sharply in the past few months, but they are still extraordinarily low from an historical perspective. While this raises the bar for new homebuyers, most are still in good shape to qualify, as the second of the above charts shows. A typical family earning a median income today still has about 66% more income than needed to qualify for a conventional loan for a median-priced house.

The above chart shows Bloomberg's Financial Conditions Index, a composite of a variety of key indicators of financial market health (e.g., implied volatility, general liquidity conditions, credit spreads). This index is now at a new high. Healthy financial markets are necessary for a healthy economy, but not sufficient, of course. We are still lacking in the confidence department, and government is still placing excessive regulatory and tax burdens on the economy. That's terribly unfortunate, but having healthy financial fundamentals does mean that the right combination of growth-oriented policies could unleash a new wave of economic growth.

Several months ago, I noted that one of the biggest changes on the margin was the rise in real yields. That's still the case today, and the above three charts help explain why. The big rise in real yields has tracked closely with the decline in gold prices (see the first of the three charts above), and that tells me that the market's appetite for "safe assets" has declined. Gold is the classic refuge from geopolitical and monetary uncertainty, and its decline tells us that the world is worried less about the possibility of a Fed-induced hyperinflation. The measure of the decline in real yields I've used is 5-yr TIPS, because they are another type of "safe asset": default-free, relatively short-term in nature, and immune to inflation. Rising real yields are the flip side of declining demand for TIPS. A decline in the demand for safe assets mirrors an increase in the world's confidence, and that bodes well for future growth.

As the second chart above shows, real yields have a strong tendency to inversely track the earnings yield on stocks. Very low real yields and very high earnings yields are symptomatic of a market that is deeply pessimistic about the prospects for economic growth and corporate profits. The recent reversal thus marks a key improvement in the market's outlook for the future.

The third chart above shows how real yields tend to track the economy's growth rate. Very high real yields are typically found at times when economic growth is very strong, and low real yields are symptomatic of weak growth. The recent rise in real yields means the market is now somewhat less pessimistic about the future.

The world still agonizes over U.S. budget deficits, but the above charts document the huge improvement there has been in the just the past few years on this front. Most of the improvement has come from stable and even declining levels of federal spending, since that shrinks the burden of government and gives the private sector more breathing room. Strong growth in revenues has also contributed, but that is more symptomatic of an improving economy (e.g., more jobs, higher incomes, higher profits) than it is of higher tax rates. It all adds up to a huge reduction in the burden of the deficit, from a high of over 10% of GDP to the current level of just over 4%. This is very positive for the future, since it dramatically reduces the likelihood of the need for higher tax rates and even opens up the possibility of tax rate reductions.

Swap spreads are critically important and sensitive indicators of systemic risk. Currently below 20 bps, they signal very healthy financial market conditions and an almost complete absence of systemic risk.

Architectural billings have been increasing for most of the past year, a clear sign that the economy has recovered enough confidence to once again begin major construction projects. The improvement here is still in its infancy, however, but that does nothing to take away from the importance of this development.

Mortgage rates typically follow the yield on 10-yr Treasuries. The spread between the two averages about 80-100 bps, and that's pretty close to where we are today. Mortgage rates have jumped along with Treasury yields, but both are still very low from an historical perspective. The recent rise in rates is very unlikely to snuff out economic growth; it's much more likely to be symptomatic of the economy's improving (though still relatively weak) economic growth fundamentals. Interest rates tend to be driven by economic activity, not the other way around. Three cheers for higher rates!

Since late last year, Japan's monetary policymakers have been making a concerted effort to reverse the deflationary forces that have plagued its economy for decades. This shows up first in a substantial devaluation of the yen. That this is a positive development shows up in the sustained rise in equity prices which has accompanied a weaker yen. What's good for Japan is going to be good for the whole world.

Thanks to new fracking technology, U.S. production of natural gas has soared and the price of natural gas has plunged, both in nominal terms and relative to the cost of oil. Since natural gas is not readily exportable, this has given energy-intensive U.S. industry a key low-cost advantage relative to overseas producers that is likely to endure for at least the next few years.

Contrary to what so many bears seem to believe, I think these charts provide convincing evidence of an economy that is gradually improving. There is nothing fictitious about the data here, and most of the charts use market-based data that is not subject to revision or faulty seasonal adjustment factors. This is real.

10 comments:

The political salespeople are still selling "optimism" -- that's how old people born before 1955 market their businesses and the political economy -- selling "optimism" was en vogue during the 20th century -- however, I'm not sure that selling "optimism" is a wise marketing approach to political economy for the 21st century -- just a hypothesis statement worth pondering...

Lamenting the very small rise in real disposable income per capita is just another way of observing that there are still fewer people working today than there were pre-recession. Jobs have not kept up with population growth. We know that. But real disposable income (for those working) is up over 6% since the end of 2009. It's the weakest recovery on record, but progress is being made. That is my point.